Crypto in danger of learning the wrong lesson from FTX


Cryptocurrency is now dealing with a crisis that has emboldened its critics and dispirited its advocates.
Cryptocurrency is now dealing with a crisis that has emboldened its critics and dispirited its advocates. | Photo illustration by Jonathan Raa/NurPhoto via Getty Images

In normal times, it is almost unthinkable that a $32bn business empire could collapse under the weight of a tweet. But these are not normal times in cryptocurrency.  

Revelations that digital asset giant, FTX, was using a token of its own creation to inflate its balance sheet initiated a run of withdrawals. When four days later the world’s biggest cryptocurrency exchange, Binance, revealed on Twitter it was eliminating its exposure to FTX’s token, the run became a canter. In a further cruel twist, FTX was apparently subject to a hack over the weekend.  

It is a desperate situation for innocent FTX customers and an astonishing turnaround. FTX’s support to struggling companies during the crypto winter had seen its CEO feted mere months ago as ‘crypto’s John Pierpont Morgan’. No-one, it seems, had any inkling FTX was rehypothecating customer assets without consent and at scale. Just a few months ago, FTX made a submission to the Securities and Exchange Commission advocating for more regulation. 

Amidst it all, cryptocurrency is now dealing with a crisis that has emboldened its critics and dispirited its advocates. Our response has been well intentioned, with the industry united in calling for greater balance sheet transparency. But the number one solution so far – publication of Merkle tree proof of reserves – is limited and complex, and perhaps even dangerous.  

A Merkle tree is used to secure transaction data in the blockchain and can be used to give customers a point of time view on assets held by an exchange. In effect, the equivalent of a real time balance sheet audit. Unfortunately, Merkle proof of reserves tell you nothing about tomorrow’s available liquidity or value. Nor whether those assets are being used as collateral against a loan. Meaning they have potential to give false comfort and still do not entirely eliminate the possibility of a future FTX.  

Our industry could learn a simple lesson from FTX. Sort out custody and treatment of customer assets. Instead, it appears to be learning a complex one. Convert records of all your customer balances into a cryptographic Merkle Tree and let people perform their own due diligence. 

Yes, there is a coherent case for third-party audited, and auditable, Merkle trees as part of a suite of measures. Or even better, traditional business audits of the kind Swyftx and other Australian exchanges have undertaken. But Merkle trees on their own are insufficient. What we really need, at both the domestic and international levels, are regulatory rules over custody.  

Policy makers around the world, currently managing high growth crypto industries, are already undertaking quick and messy improvisations in a bid to protect local consumers and promote innovation.

FTX is a sad reminder of the need to bring forward appropriate consumer protections. There are risks in cryptocurrency that require oversight. Not self-regulation. A point that is now manifestly true of custody of assets, but also includes cyber resilience, financial advice, fit and proper person tests for people running exchanges, and capital requirements.  

The solution doesn’t need to be perfect. It just needs to be better than what we have now. On top of this, it needs to be proportionate.  Australian exchanges don’t exist because we want them to. They exist because customers want them. Domestic regulation that is too draconian would simply leave Australian crypto-users fending for themselves in the unregulated world of defi.  

At home, the simplest and (crucially) quickest answer is just to regulate cryptocurrency exchanges under a version of the existing Australian financial services licensing regime (AFSL) that takes into account the idiosyncrasies of the cryptocurrency market. It might not have the pizzazz of a new framework, but it requires less work and immediately reduces the risk of Australians transacting through poorly managed businesses.  

But if we are to start improving consumer protection in the Crypto space and prevent a future FTX, it would be best, to paraphrase Macbeth, for regulation to be done and be done quick. 

Alex Harper is one of the co-founders of Australian digital assets exchange Swyftx.

Further reading: From school science camp to $1.5 billion merger: Swyftx